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Money creation

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Money creation

In economics, money creation is the process by which the money supply of a country or a monetary region (such as the Eurozone) is increased. A central bank may introduce new money into the economy (termed "expansionary monetary policy", or "money printing" by detractors) by purchasing financial assets or lending money to financial institutions. Commercial bank lending also creates money under the form of demand deposits. When banks had reserve requirements (freezing a percentage of their deposits in mandatory reserves at the central bank) the process multiplied this base money through fractional reserve banking.

Central banks monitor the amount of money in the economy by measuring monetary aggregates such as M2. The effect of monetary policy on the money supply is indicated by comparing these measurements on various dates. For example, in the United States, money supply measured as M2 grew from $6.407 trillion in January 2005, to $8.319 trillion in January 2009.[1]

Contents

  • Money creation by the commercial banks 1
    • Quantitative easing 1.1
  • Physical currency 2
  • Money creation through the fractional reserve system 3
    • Re-lending 3.1
    • Money multiplier 3.2
  • Alternative theories 4
  • See also 5
  • References 6
  • External links 7

Money creation by the commercial banks

In the contemporary economic system, most money in circulation exists not as cash or coins but as bank deposits. The main way in which those bank deposits are created, is through loans made by commercial banks. When a bank makes a loan, a deposit is created at the same time in the borrower's bank account. In that way, new money is created as a bookkeeping entry, with the loan representing an asset and the deposit a liability on the bank's balance sheet. [2]

Monetary policy regulates a country's money supply, the amount of broad currency in circulation. Almost all modern nations have central banks such as the United States Federal Reserve System, the European Central Bank (ECB), the Reserve Bank of India, Central bank of Pakistan, and the People's Bank of China for conducting monetary policy. Charged with the smooth functioning of the money supply and financial markets, these institutions are generally independent of the government executive.

The primary tool of monetary policy is open market operations: the central bank buys and sells financial assets such as treasury bills, government bonds, or foreign currencies from private parties. Purchases of these assets result in currency entering market circulation, while sales of these assets remove currency. Usually, open market operations are designed to target a specific short-term interest rate. For example, the U.S. Federal Reserve may target the federal funds rate, the rate at which member banks lend to one another overnight. In other instances, they might instead target a specific exchange rate relative to some foreign currency, the price of gold, or indices such as the consumer price index.

Other monetary policy tools to expand the money supply include decreasing interest rates by fiat; increasing the monetary base; and decreasing reserve requirements. Some other means are: discount window lending (as lender of last resort); moral suasion (cajoling the behavior of certain market players); and "open mouth operations" (publicly asserting future monetary policy). The conduct and effects of monetary policy and the regulation of the banking system are of central concern to monetary economics.

Quantitative easing

Quantitative easing involves the creation of a significant amount of new base money by a central bank by the buying of assets that it usually does not buy. Usually, a central bank will conduct open market operations by buying short-term government bonds or foreign currency. However, during a financial crisis, the central bank may buy other types of financial assets as well. The central bank may buy long-term government bonds, company bonds, asset-backed securities, stocks, or even extend commercial loans. The intent is to stimulate the economy by increasing liquidity and promoting bank lending, even when interest rates cannot be pushed any lower.

Quantitative easing increases reserves in the banking system (i.e., deposits of commercial banks at the central bank), giving depository institutions the ability to make new loans. Quantitative easing is usually used when lowering the discount rate is no longer effective because interest rates are already close to or at zero. In such a case, normal monetary policy cannot further lower interest rates, and the economy is in a liquidity trap.

Physical currency

In modern economies, relatively little of the supply of broad money is in physical currency. For example, in December 2010 in the United States, of the $8.853 trillion in broad money supply (M2), only about 10% (or $915.7 billion) consisted of physical coins and paper money.[3] The manufacturing of new physical money is usually the responsibility of the central bank, or sometimes, the government's treasury.

Contrary to popular belief, money creation in a modern economy does not directly involve the manufacturing of new physical money, such as paper currency or metal coins. Instead, when the central bank expands the money supply through open market operations (e.g., by purchasing government bonds), it credits the accounts that commercial banks hold at the central bank (termed high-powered money). Commercial banks may draw on these accounts to withdraw physical money from the central bank. Commercial banks may also return soiled or spoiled currency to the central bank in exchange for new currency.[4]

Money creation through the fractional reserve system

Through fractional reserve banking, the modern banking system expands the money supply of a country beyond the amount initially created by the central bank.[5] There are two types of money in a fractional-reserve banking system: currency originally issued by the central bank, and bank deposits at commercial banks:[6][7]

  1. Central bank money (all money created by the central bank regardless of its form, e.g., banknotes, coins, electronic money)
  2. Commercial bank money (money created in the banking system through borrowing and lending) – sometimes referred to as checkbook money[8]

When a commercial bank loan is extended, new commercial bank money is created if the loan proceeds are issued in the form of an increase in a customer's demand deposit account (that is, an increase in the bank's demand deposit liability owed to the customer). As a loan is paid back through reductions in the demand deposit liabilities the bank owes to a customer, that commercial bank money disappears from existence. Because loans are continually being issued in a normally functioning economy, the amount of broad money in the economy remains relatively stable. Because of this money creation process by the commercial banks, the money supply of a country is usually a multiple larger than the money issued by the central bank; that multiple was traditionally determined by the reserve requirements and now essentially by other financial ratios (primarily the capital adequacy ratio that limits the overall credit creation of a bank) set by the relevant banking regulators in the jurisdiction.

Re-lending

An early table, featuring reinvestment from one period to the next and a geometric series, is found in the tableau économique of the Physiocrats, which is credited as the "first precise formulation" of such interdependent systems and the origin of multiplier theory.[9]

Money multiplier

The expansion of $100 through fractional-reserve lending under the re-lending model of money creation, at varying rates. Each curve approaches a limit. This limit is the value that the money multiplier calculates. Note that the top amount resulting in $1000 is not 20% but 10% as 100/0.1=1000.

The most common mechanism used to measure this increase in the money supply is typically called the money multiplier. It calculates the maximum amount of money that an initial deposit can be expanded to with a given reserve ratio – such a factor is called a multiplier. And is the maximum amount of money commercial banks can legally create for a given quantity of reserves.

It is calculated as

M=\frac{1}{R}

Where

M = Deposit Multiple

R = Required Reserve Ratio

In the re-lending model, this is alternatively calculated as a geometric series under repeated lending of a geometrically decreasing quantity of money: reserves lead loans. In endogenous money models, loans lead reserves, and it is not interpreted as a geometric series. In practice, because banks often have access to lines of credit, and the money market, and can use day time loans from central banks, there is often no requirement for a pre-existing deposit for the bank to create a loan and have it paid to another bank.[10][11]

The money multiplier is of fundamental importance in monetary policy: if banks lend out close to the maximum allowed, then the broad money supply is approximately central bank money times the multiplier, and central banks may finely control broad money supply by controlling central bank money, the money multiplier linking these quantities; this was the case in the United States from 1959 through September 2008.

If, conversely, banks accumulate excess reserves, as occurred in such financial crises as the Great Depression and the Financial crisis of 2007–2008 – in the United States since October 2008, then this equality breaks down, and central bank money creation may not result in commercial bank money creation, instead remaining as unlent (excess) reserves.[12] However, the central bank may shrink commercial bank money by shrinking central bank money, since reserves are required – thus fractional-reserve money creation is likened to a string, since the central bank can always pull money out by restricting central bank money, hence reserves, but cannot always push money out by expanding central bank money, since this may result in excess reserves, a situation referred to as "pushing on a string".

Alternative theories

There are also heterodox theories of how money is created. These include:

  • Chartalism sees the state as creating money when it spends, and destroying it when it taxes. More importantly, the private banking system is not, in empirical terms, reserve-limited, so its creation of money is an endogenous process, driven by credit demand and lending willingness. This accounts for the power of the state's interest rate policy in governing most of the money supply in normal times. [13][14]
  • Credit Theory of Money. This approach was initiated by Joseph Schumpeter. Credit theory asserts the central role of banks as creators and allocators of money supply, and distinguishes between "productive credit creation" (allowing non-inflationary economic growth even at full employment, in the presence of technological progress) and "unproductive credit creation" (resulting in inflation of either the consumer- or asset-price variety).[15][16]

See also

References

  1. ^ US Federal Reserve historical statistics June 11, 2009
  2. ^ "In the modern economy, most money takes the form of bank deposits. But how those bank deposits are created is often misunderstood: the principal way is through commercial banks making loans. Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money." Michael McLeay et al, Quarterly Bulletin 2013 Q1, http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q102.pdf
  3. ^ Federal Reserve Statistic February 17, 2011
  4. ^
  5. ^ Modern Money Mechanics
  6. ^ Bank for International Settlements – The Role of Central Bank Money in Payment Systems. See page 9, titled, "The coexistence of central and commercial bank monies: multiple issuers, one currency": http://www.bis.org/publ/cpss55.pdf A quick quote in reference to the 2 different types of money is listed on page 3. It is the first sentence of the document: "Contemporary monetary systems are based on the mutually reinforcing roles of central bank money and commercial bank monies."
  7. ^ European Central Bank – Domestic payments in Euroland: commercial and central bank money: http://www.ecb.int/press/key/date/2000/html/sp001109_2.en.html One quote from the article referencing the two types of money: "At the beginning of the 20th almost the totality of retail payments were made in central bank money. Over time, this monopoly came to be shared with commercial banks, when deposits and their transfer via checks and giros became widely accepted. Banknotes and commercial bank money became fully interchangeable payment media that customers could use according to their needs. While transaction costs in commercial bank money were shrinking, cashless payment instruments became increasingly used, at the expense of banknotes"
  8. ^ Chicago Fed – Our Central Bank: http://www.chicagofed.org/consumer_information/the_fed_our_central_bank.cfm
  9. the reference is found in the "Money Manager" section:
  10. "the Fed works to control money at its source by affecting the ability of financial institutions to "create" checkbook money through loans or investments. The control lever that the Fed uses in this process is the "reserves" that banks and thrifts must hold."
  11. ^ The multiplier theory, by Hugo Hegeland, 1954, p. 1
  12. ^
  13. ^
  14. ^ (Samuelson 1948, pp. 353–354): By increasing the volume of their government securities and loans and by lowering Member Bank legal reserve requirements, the Reserve Banks can encourage an increase in the supply of money and bank deposits. They can encourage but, without taking drastic action, they cannot compel. For in the middle of a deep depression just when we want Reserve policy to be most effective, the Member Banks are likely to be timid about buying new investments or making loans. If the Reserve authorities buy government bonds in the open market and thereby swell bank reserves, the banks will not put these funds to work but will simply hold reserves. Result: no 5 for 1, “no nothing,” simply a substitution on the bank’s balance sheet of idle cash for old government bonds.
  15. ^
  16. ^
  17. ^ See:
  18. ^ See also:

External links

  • Bank for International Settlements – The Role of Central Bank Money in Payment Systems
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